Revisiting the Fed’s Crisis

by J. Bradford DeLongJ. Bradford DeLong, a former deputy assistant secretary of the US Treasury, is Professor of Economics at the University of California at Berkeley and a research associate at the National Bureau of Economic Research.01.03.2014

BERKELEY – Reading through the just-released transcripts of the US Federal Reserve’s Federal Open Market Committee meetings in 2008, I found myself asking the same overarching question: What accounted for the FOMC’s blinkered mindset as crisis erupted all around it?

To be sure, some understood the true nature of the situation. As Jon Hilsenrath of the Wall Street Journal points out, William Dudley, then the executive vice president of the New York Fed’s Markets Group, presented staff research that sought, politely and compellingly, to turn the principals’ attention to where it needed to be focused. And FOMC members Janet Yellen, Donald Kohn, Eric Rosengren, and Frederic Mishkin, along with the Board of Governors in Washington clearly got the message. But the FOMC’s other eight members, and the rest of the senior staff? Not so much (albeit to greatly varying degrees).

As I read the transcripts, I recalled the long history dating back to 1825, and before, in which the uncontrolled failure of major banks triggered panic, a flight to quality, the collapse of asset prices, and depression. But there in the FOMC’s mid-September 2008 report, many members express self-congratulation for having found the strength to take the incomprehensible decision not to bail out Lehman Brothers.

I find myself thinking back to the winter of 2008, when I stole – and used as much as possible – an observation by the economist Larry Summers. In the aftermath of the housing bubble’s collapse and extraordinary losses in the derivatives market, Summers noted, banks would have to diminish leverage. While it would not matter much to any individual bank whether it did so by reducing its loan portfolio or by raising its capital, it mattered very much to the economy that the banks chose the second.

Even today, I cannot comprehend then-New York Fed President Timothy Geithner’s declaration in March 2008 that, “it is very hard to make the judgment now that the financial system as a whole or the banking system as a whole is undercapitalized.” Geithner’s view at the time was that “there is nothing more dangerous…than for people…to feed…concerns about…the basic core strength of the financial system.” Of course, we now know that indifference to such concerns turned out to be far more dangerous.

Likewise, I look at history and see that it is core inflation (which strips out volatile food and energy prices), not headline inflation, that matters for predicting future inflation (even future headline inflation). Then I read declarations like that by Dallas Federal Reserve President Richard Fisher, that dangerous inflationary pressure was building during the summer of 2008, and I find myself at a loss.

Some of the 2008-era mindset (most of it?) most likely stemmed from the fact that there are things that are very real and solid to monetary economists. We can see, touch, and feel how a financial-deleveraging cycle depresses aggregate demand. We know that this year’s change in an inertial price, such as wages, tells us a lot about next year’s wage changes, while this year’s change in a non-inertial price, such as oil, tells us next to nothing. And we know how herd behavior by investors means that a single salient bank failure can turn a financial mania into a panic, and then a crash.

But others do not see, touch, and feel these things. For non-economists, they are simply shadows on the walls of a cave.

That distinction was less relevant in the past. The Fed of old usually had a charismatic, autocratic, professional central banker at its head: Benjamin Strong, Marriner Eccles, William McChesney Martin, Paul Volcker, and Alan Greenspan. When it worked – which was not always true – the chair ruled the FOMC with an iron hand and with the near-lockstep voting support of the governors. The views of the other members – with their varying backgrounds in banking, regulation, and elsewhere – were of little or no concern.

But former Chairman Ben Bernanke’s FOMC was different. It was collegial, respectful, and consensus-oriented. As a result, there was a deep disconnect between Bernanke’s policy views, which followed from his analyses in the 1980’s and 1990’s of the Great Depression and Japan’s “lost decades,” and the FOMC’s failure in 2008 to sense what was coming and to guard against the major downside risks.

So I find myself wondering: What if those who understood the nature of the crisis and those who did not had been compelled to make their cases to Bernanke in private? If Bernanke had then said, “This is what we are going to do,” rather than seeking consensus – that is, if Bernanke’s Fed had been like the old Fed – would better monetary-policy decisions have been made in 2008?

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